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Types of Bonds

Types of Bonds

This document outlines various types of bonds, categorized by issuer, interest payment structure, and other key characteristics. Understanding these different types is crucial for investors looking to build a diversified portfolio and manage risk.

I. By Issuer

1. Government Bonds (Sovereign Bonds)

  • Definition: Bonds issued by national governments to finance spending and investment.
  • Examples: US Treasuries, UK Gilts, German Bunds, Japanese Government Bonds (JGBs).
  • Risk: Generally considered low-risk, especially those issued by stable, developed economies, although they are not risk-free.
    • Default risk is typically low, but can exist.
  • Purpose: Used to fund national spending, infrastructure projects and can be used as a low-risk asset in an investment portfolio.

2. Municipal Bonds (Munis)

  • Definition: Bonds issued by state, city, county, or other government entities.
  • Purpose: Used to finance public projects like schools, hospitals, and infrastructure.
  • Tax Advantage: Often exempt from federal and/or state taxes, making them attractive to some investors.
  • Risk: Varies depending on the issuer's financial health; generally low to medium risk.

3. Corporate Bonds

  • Definition: Bonds issued by companies to finance business activities.
  • Risk: Higher risk than government bonds due to potential for company-specific issues such as poor performance or bankruptcy.
  • Yield: Generally offer higher yields than government bonds to compensate for the higher risk.
  • Types: Can be further classified by maturity or feature (e.g., investment-grade, high-yield, convertible).

4. Supranational Bonds

  • Definition: Bonds issued by international organizations or supranational entities, like the World Bank or the European Investment Bank
  • Risk: Usually seen as low risk, due to their backing from the organisations that have issued them.
  • Purpose: Used to finance projects that have international goals or benefits.

5. Agency Bonds

  • Definition: Bonds issued by government-sponsored agencies or entities, such as Fannie Mae and Freddie Mac in the USA.
  • Purpose: Used to fund specific sectors of the economy, such as housing and agriculture.
  • Risk: Lower risk than corporate bonds, but not guaranteed by the government and so higher risk than government bonds.

II. By Interest Payment Structure

1. Fixed-Rate Bonds

  • Definition: Bonds that pay a fixed coupon rate (interest rate) throughout their term.
  • Predictability: Provide a predictable stream of income.
  • Risk: Subject to inflation risk, as the real value of the fixed payments may decrease over time.

2. Floating-Rate Bonds (FRNs)

  • Definition: Bonds where the coupon rate is variable, often tied to a benchmark interest rate (e.g., LIBOR or SOFR).
  • Protection from Rate Hikes: Can provide some protection against rising interest rates.
  • Unpredictable Income: The level of income can vary depending on market interest rate changes.

3. Zero-Coupon Bonds

  • Definition: Bonds that do not pay regular interest payments.
  • Discounted Price: Sold at a discount to their face value (par value), and the investor receives the full face value at maturity.
  • Reinvestment Risk: No regular income is received, which reduces flexibility, and has more reinvestment risk.
  • Examples: US Treasury Bills

4. Inflation-Linked Bonds (Index-Linked Bonds)

  • Definition: Bonds where the principal amount and/or the interest payments are adjusted to reflect changes in an inflation index (e.g., Consumer Price Index).
  • Protection from Inflation: Protect investors from the effects of rising inflation.
  • Examples: US Treasury Inflation-Protected Securities (TIPS), UK Index-Linked Gilts.

III. By Maturity

1. Short-Term Bonds

  • Definition: Bonds with maturities of less than 3 years.
  • Lower Interest Rate Risk: Less sensitive to changes in interest rates.
  • Lower Returns: Generally offer lower yields than longer-term bonds.

2. Medium-Term Bonds

  • Definition: Bonds with maturities between 3 and 10 years.
  • Balanced Approach: Strike a balance between risk and return.

3. Long-Term Bonds

  • Definition: Bonds with maturities of more than 10 years.
  • Higher Interest Rate Risk: More sensitive to changes in interest rates.
  • Higher Potential Returns: Generally offer higher yields than short and medium-term bonds.

IV. By Other Features

1. Callable Bonds

  • Definition: Bonds that give the issuer the right to redeem them prior to the maturity date.
  • Call Risk: The risk that the bond will be called when interest rates fall, and the investor will be forced to reinvest at lower yields.

2. Puttable Bonds

  • Definition: Bonds that give the bondholder the right to sell them back to the issuer at a specified price, usually at a specific date.
  • Investor Protection: Can provide some protection from falling prices.

3. Convertible Bonds

  • Definition: Bonds that can be converted into a specific number of shares of the issuing company's stock, usually at specific times and under specified conditions.
  • Hybrid Security: Offers both the fixed income feature of a bond and the growth potential of a stock.

4. High-Yield Bonds (Junk Bonds)

  • Definition: Bonds issued by companies with lower credit ratings.
  • Higher Risk: Carry a higher risk of default but offer higher yields to compensate.

5. Investment Grade Bonds

  • Definition: Bonds issued by companies with higher credit ratings.
  • Lower Risk: Have a lower risk of default, but offer lower yields than high-yield bonds.

6. Perpetual Bonds

  • Definition: Bonds that do not have a maturity date, also called consoles.
  • Payment: They continue to pay a regular income, but there is no repayment of the principal.

In Summary

Bonds come in a wide variety of types, each with different characteristics and risk profiles. Understanding these different types—by issuer, interest structure, maturity, and other features—is essential for investors looking to build a portfolio to match their risk tolerance and investment goals.

Asset-Backed Securities (ABSs)

I. What are Asset-Backed Securities (ABSs)?

  • Definition: Financial securities backed by a pool of underlying assets, such as loans, leases, or receivables.
  • Key Feature: These assets are "securitized," meaning they are packaged together and sold as bonds to investors.
  • Purpose: ABSs allow lenders (originators) to remove assets from their balance sheets, freeing up capital and spreading risk. They also provide investors with opportunities to invest in specific asset classes.

II. How ABSs Work: The Securitization Process

  1. Origination:
    • Lenders (e.g., banks, finance companies) originate various types of loans (e.g., auto loans, mortgages, credit card debt).
  2. Pooling:
    • Lenders group similar loans together into a pool. This pool becomes the underlying asset for the ABS.
  3. Special Purpose Vehicle (SPV):
    • The pool of assets is transferred to a separate legal entity, the SPV (also known as a Special Purpose Entity - SPE).
    • The SPV is created solely for the purpose of holding these assets and issuing ABSs.
    • This isolates the assets from the originator's balance sheet, protecting them from the originator's financial difficulties.
  4. Issuance:
    • The SPV issues ABSs (bonds) to investors.
    • These ABSs are backed by the cash flows generated by the underlying assets in the pool (loan repayments).
  5. Payment:
    • As borrowers make payments on the loans, these cash flows are passed through to the ABS holders, after certain costs and fees.
  6. Credit Enhancement:
    • To make the ABS more attractive to investors, various forms of credit enhancement are used, which increase the likelihood of investors receiving the correct payments.
      • Examples:
        • Overcollateralization: Having a pool of assets that is worth more than the face value of the securities.
        • Subordination: Creating different tranches of securities, with the senior tranches being paid before junior ones.
        • Guarantees and Credit Insurance: Third-party guarantees and insurance policies.

III. Types of Asset-Backed Securities

  • Mortgage-Backed Securities (MBS):
    • Underlying Assets: Residential or commercial mortgage loans.
    • Examples:
      • Residential Mortgage-Backed Securities (RMBS): Backed by home mortgages.
      • Commercial Mortgage-Backed Securities (CMBS): Backed by loans on commercial properties.
  • Auto Loan ABS:
    • Underlying Assets: Auto loans.
  • Credit Card ABS:
    • Underlying Assets: Credit card receivables.
  • Student Loan ABS:
    • Underlying Assets: Student loans.
  • Collateralized Loan Obligations (CLOs):
    • Underlying Assets: Bank loans to companies.

IV. Key Characteristics of ABSs

  • Variety of Asset Types: Backed by diverse assets, offering exposure to different markets.
  • Tranching: Often structured into different tranches (or classes) of securities with varying levels of risk and return (senior, mezzanine, and equity).
  • Cash Flow Driven: Payments to investors are tied to the performance and cash flows of the underlying assets.
  • Credit Ratings: Usually rated by credit rating agencies, providing an assessment of credit risk.
  • Potential for Diversification: Allows investors to gain exposure to specific asset classes without directly owning the underlying assets.

V. Benefits of ABSs

  • For Originators:
    • Frees up capital to originate new loans.
    • Diversifies funding sources.
    • Reduces risk by transferring it to investors.
  • For Investors:
    • Provides access to asset classes not normally available.
    • Offers a range of risk and return profiles based on different tranches.
    • Can diversify a portfolio.

VI. Risks Associated with ABSs

  • Credit Risk: Risk of borrowers defaulting on their loans.
  • Prepayment Risk: Risk that borrowers may pay off their loans early, reducing the cash flow to investors.
  • Interest Rate Risk: Risk that changing interest rates will negatively affect ABS prices.
  • Complexity: ABSs can be complex and difficult to understand.
  • Liquidity Risk: Some ABSs may not be easily traded in the secondary market.
  • Model Risk: Risk that valuation models used to assess the value of ABSs might not accurately reflect real market conditions.
  • Transparency Issues: The complexity of some ABS can make it difficult for investors to understand the risks involved.
  • Correlation Risk: Although diversification is a key aim of ABS, some underlying assets can be highly correlated. This was seen during the 2008 crisis where mortgage-backed securities were correlated.

VII. ABSs and the 2008 Financial Crisis

  • Role in the Crisis: Mortgage-backed securities (MBS) played a key role in the 2008 financial crisis.
  • Subprime Lending: The crisis was triggered by the collapse of subprime mortgages (loans to borrowers with poor credit).
  • Complex Products: The complexity of MBS and the interconnected nature of financial markets made the crisis more widespread and severe.
  • Regulatory Changes: The financial crisis led to new regulations aimed at increasing transparency and reducing risks associated with securitization.

In Summary

Asset-Backed Securities (ABSs) are complex financial instruments that package together assets like loans, allowing lenders to free up capital and investors to access diverse markets. While they offer various benefits, they also come with risks, as demonstrated by the 2008 financial crisis. A thorough understanding of these instruments is vital for both originators and investors.

Bond Yields

I. Understanding Bond Yields

  • Definition: Yields measure the returns an investor can expect to earn from holding a bond.
  • Coupon vs. Yield:
    • Coupon: The stated interest rate on a bond's nominal (face) value.
    • Yield: A more comprehensive measure of return, taking into account the bond's current price.

II. Types of Yields

1. Flat Yield (Running Yield)

  • Definition: The interest paid on a bond as a percentage of its market price.
  • Calculation: (Annual Coupon / Bond's Price) * 100
  • Purpose: Provides a quick measure of the current income being generated by the bond, based on its current market value.
  • Example: If a bond pays a coupon of $5 a year, and it costs $100, then the flat yield is 5%.
    • If that same bond now costs $110, the flat yield would be 4.55%
    • If that same bond now costs $90, the flat yield would be 5.56%
  • Limitations: Does not consider the potential capital gain or loss if the bond is held to maturity.

2. Redemption Yield (Yield to Maturity - YTM)

  • Definition: A measure that incorporates both the income (coupon payments) and the capital return (gain or loss) if a bond is held until maturity.
  • Purpose: Provides a more accurate picture of a bond's total return, offering a better basis for comparison between bonds.
  • Calculation: A more complex calculation that takes into account a bond's current price, coupon rate, time to maturity, and par value. It’s essentially the internal rate of return (IRR) of the investment.
  • Example: Consider a bond with a par value of $100, which is currently trading at $96.18 and which pays a coupon of 1.875%.
    • The flat yield is 1.875/96.18 = 1.95%.
    • However, the bond will return $100 when it matures, so there is a capital gain of $3.82 to consider.
    • Therefore, when all factors are considered the yield to maturity is more than the flat yield of 1.95%.
  • Key Concepts:
    • Par Value (Face Value): The nominal value of the bond that will be paid at maturity (e.g., $100).
    • Market Price: The current price at which the bond is trading.
    • Capital Gain: If the bond is purchased below par (discount) and held to maturity, the investor will make a capital gain.
    • Capital Loss: If the bond is purchased above par (premium) and held to maturity, the investor will make a capital loss.

III. Relationship Between Market Price and Yield to Maturity

  • Bond Priced at a Discount:

    • If a bond's market price is lower than its par value, the yield to maturity will be higher than the flat yield.
    • This is because there will be a capital gain if the bond is held until maturity.

  • Bond Priced at a Premium:

    • If a bond's market price is higher than its par value, the yield to maturity will be lower than the flat yield.
    • This is because there will be a capital loss if the bond is held until maturity.

  • Bond Priced at Par:

    • If a bond is trading at its par value, the yield to maturity and flat yield will be the same.

IV. Importance of Yield to Maturity

  • Accurate Indication: Provides a more accurate indication of the total return that an investor can expect.
  • Comparison Tool: Allows investors to compare the returns from different bonds, helping to identify which offers the best return on an annualised basis.

In Summary

Yields are a crucial measure for bond investors. While the flat yield provides a quick look at the current income, the yield to maturity offers a more comprehensive view of total return, considering both income and any capital gain or loss. Understanding the relationship between bond prices, coupon rates, and yields is essential for making informed investment decisions.

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